Help clients avoid the horrors of a residency audit

Financial planners can share horror stories about clients who suffered through residency audits conducted by state tax authorities and, in some cases, even failed to pass those tests.

One inventor, Gilbert Hyatt, who received a lucrative patent for a microprocessor and moved from California to Nevada has been engaged in a nearly quarter-century-long legal battle with California auditors about his residency status. The California residency auditors have conducted aggressive investigations, and even rifled through his garbage, the inventor has asserted in court filings.

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I would not tell every client to concede in an audit. -Shomari Hearn

Twice, the inventor’s lawyers have gone before the U.S. Supreme Court, which on April 19 ruled that Nevada could not give its own citizens special protection against the actions of another state when it would not provide the same shield for them against its own actions. The high court’s ruling likely slashed the inventor’s previous $1 million jury award from a Nevada state court to $50,000, and left him still having to continue his residency fight in a California court.

Although rarely so grueling, residency audits nonetheless often follow clients’ attempts to move and halt their status as tax-paying residents in their former home states, in which they may want to continue to live part-time.

LETTER FROM TAX AGENCYNot all clients who get a letter from a state’s tax agency announcing a residency audit should immediately throw in the towel, according to veteran financial planners, accountants, and lawyers familiar with the process.

Adviser Shomari Hearn

“I would not tell every client to concede in an audit,” says Shomari Hearn, an adviser and CFP with Palisades Hudson Financial Group in Fort Lauderdale, Fla.

Clients who find themselves in such situations definitely should be wary. In some states — notably New York — the agencies conduct these audits aggressively. Clients must be prepared since the stakes — and potential income tax liabilities — are high. To pass the audit, they should be armed with a comprehensive checklist of documentation.

Hearn, whose firm manages $1.1 billion in assets and has offices in New York and Florida, recommends clients show they have broken domicile with their former home state by taking several concrete steps. To start, such clients should declare their residency with the county government in their new state, he says.

Then, they should register to vote, obtain a driver’s license and register their vehicles in their new state. They should redirect all statements from banks and other financial institutions to their residential address in the new state.

PASS THE SMELL TESTBut the checklist doesn’t end there because auditors can go beyond the obvious signs of a residency.

Adviser Sheryl Rowling

“It’s not black and white, it’s not a bright line,” says Sheryl Rowling. A financial adviser who is also a CPA, Rowling spoke about the rules in her home state of California that govern the state tax agency’s residency audits.

No discrete list of qualifiers determines residency in California, she says. Instead, the state lets its residency auditors consider facts and circumstances, explains the owner of San Diego-based Rowling & Associates, with more than $260 million in assets under management.

But what does facts and circumstances really mean?

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What matters is how your family members and friends perceive your residency. -Sheryl Rowling

“You have to pass the smell test. What matters is how your family members and friends perceive your residency,” she says. Auditors “want to make sure people are not pretending to be residents of another state to avoid paying taxes. If someone is really a California resident, California wants to tax all their income,” she says.

Rowling recommends clients find doctors, and even hairdressers, in their new state. “You truly have to have a residency in the new state,” she warns.

Hearn agrees a certain residency gestalt is what counts. He even recommends clients move the lion’s share of their valuable objects — such as works of art — to the new state.

Robert Alter, a lawyer and partner in Morristown, New Jersey-based McElroy, Deutsch, Mulvaney & Carpenter, also ranks New York as having the most aggressive audit program in the nation, but says other states with high income and estate taxes, such as Connecticut, Massachusetts, New Jersey, California, North Carolina and Idaho, also have very active residency auditors.

BUY A CEMETERY PLOT?To prevail with those aggressive auditors, clients should remember: “The devil is in the details,” Alter says. Clients should plan and document all the issues related to their changed residency. Alter and other financial planners recommend that a person who gets an audit notice seek an adviser. Attorneys with expertise, including Alter, charge between $350 and $750 per hour, he says.

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Alter goes so far as to tell clients to buy a cemetery plot in their new state.

Alter goes so far as to tell clients to buy a cemetery plot in their new state.

For the inventor whose tussle with California residency auditors began nearly two decades ago and who recently heard from the nation’s highest court, such forward thinking might not sound so far-fetched.